Puerto Rico Junk Grades Spur Barclays Index Shakeup: Muni Credit

Feb. 10 (Bloomberg) -- Puerto Rico’s downgrade to junk by a
second ratings company is set to realign $13 billion of debt in
Barclays Plc indexes that serve as benchmarks for most municipal
mutual funds.

The company’s broadest muni index requires that for issuers
with three ratings, two must be investment grade. The U.S.
commonwealth was cut to junk by Standard & Poor’s on Feb. 4 and
by Moody’s Investors Service three days later. Puerto Rico bonds
represent 2.5 percent of the $1.28 trillion Barclays benchmark,
the bank said in a Feb. 4 report.

The downgrades will alter benchmarks used by 82 percent of
municipal mutual funds, including nine of the 10 largest,
Morningstar Inc. data show. The island’s presence in the indexes
may have prevented some selling, said Peter DeGroot at J.P.
Morgan Securities LLC and Bart Mosley at Trident Municipal
Research. Its removal would give investors one less reason to
own the securities after the biggest losses since at least 1999.

“Portfolio managers have had to think long and hard about
not having some Puerto Rico exposure because they’re giving up
that extra yield that’s in the index,” Mosley said. “If it
falls out of the index after the other agencies downgrade them,
they won’t have that incentive to own it.”

Exit Sign

About $13 billion of Puerto Rico debt may exit the broad
Barclays muni index at month-end after the rating cuts,
according to the bank’s report. About 70 percent of U.S.
municipal-bond mutual funds hold the island’s securities, which
are tax-exempt nationwide. The ownership, even in state-specific
funds, gives the commonwealth’s finances outsized influence in
the $3.7 trillion local-debt market.

Fitch Ratings, which assigns the self-governing
commonwealth the lowest investment grade, said in November that
it may drop it to junk by June 30. Speculative grade begins at
BB+ for Fitch and S&P, and at Ba1 for Moody’s.

Puerto Rico and its agencies have $70 billion of debt,
according to the island’s Government Development Bank, which
handles bond sales. In a 2013 Moody’s study of state debt loads,
only California and New York had more gross tax-supported
obligations. The burden, coupled with an economy that contracted
in six of the last seven years, has fueled concern that the
island won’t be able to repay investors.

Yield Guide

Commonwealth securities have traded at yields consistent
with speculative-grade bonds since at least September.

General obligations maturing in July 2041 traded today with
an average yield of 8.15 percent, down from 8.24 percent on Feb.
7 and the lowest level since November, Bloomberg data show. The
securities yielded about 5 percent a year ago.

Investors have held Puerto Rico in part because “you don’t
want to have an index that has a yield that’s higher than your
fund,” said DeGroot, a strategist at J.P. Morgan in New York.
“Given the compounding nature of total returns, you can very
quickly trail your benchmark by a significant amount in those
instances.”

The speculative ratings may limit buyers for Puerto Rico
because some funds require managers to purchase investment-grade
obligations.

For example, at OppenheimerFunds Inc., if all three major
rating companies grade the commonwealth junk and that leaves
funds with more speculative-grade debt than prospectuses allow,
managers won’t be able to add high-yield until the allocation
falls to acceptable levels, according to a statement on the
asset manager’s website.

The company is the largest holder of Puerto Rico debt among
mutual funds, data compiled by Bloomberg show. Kristen Prestano,
a spokeswoman, said no fund managers were available to comment.

Future Liquidity

“Most funds don’t have to sell on one or two downgrades,”
said Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors. “It’s not so much about who
holds the bonds now -- the question for Puerto Rico is who’s
going to provide liquidity and capital to purchase the bonds in
the near future.”

Puerto Rico Governor Alejandro Garcia Padilla and lawmakers
are working on a bill authorizing as much as $3.5 billion of
general-obligation debt, Representative Rafael “Tatito”
Hernandez said last week. Soaring interest rates last year
halted issuance of as much as $1.2 billion of sales-tax bonds.

Puerto Rico officials have said the commonwealth has enough
liquidity to satisfy all its needs until June 30, the end of the
fiscal year.

‘Strongly Disagree’

“We strongly disagree with Moody’s decision, and we will
not relent in our plans to strengthen our fiscal situation,”
GDB Chairman David Chafey and Treasury Secretary Melba Acosta
said in a statement on Feb. 7.

“We remain confident that we have the liquidity on hand to
satisfy all liquidity needs until the end of the fiscal year,
including any cash needs resulting from recent rating agency
actions,” they said.

Of the bonds that could leave the Barclays index with two
downgrades, about $4.9 billion are general obligations, $3.3
billion are from the electric power authority, $2.2 billion from
the public buildings authority, $1.3 billion from the highways
agency, $1.1 billion from the infrastructure financing authority
and $500 million is debt from other agencies, according to Tom
Weyl, director of muni research at Barclays in New York.

Sales-tax-backed bonds, known as Cofinas, along with pre-refunded debt and securities backed by units of Assured Guaranty
Ltd. and MBIA Inc. will probably keep their investment grades,
Weyl wrote in the report. He declined to comment beyond the
research.

Adjustment Phase

Puerto Rico will comprise 21 percent of Barclays’ high-yield index after the company adjusts it following the second
downgrade. That would be up from 5 percent and would give the
commonwealth the largest weighting among states.

Eight muni mutual funds use the broad high-yield index as a
benchmark, compared with 262 for the broad index, Morningstar
data show.

Removing Puerto Rico bonds will lower interest rates on
investment-grade indexes. For example, taking out Electric Power
Authority debt would drop the yield on the index tracking the
electric power industry to 2.63 percent from 3.02 percent,
according to Barclays.

S&P removed bonds from Puerto Rico and other triple tax-exempt territories such as Guam and the Virgin Islands from its
National AMT-Free Municipal index as of Jan. 31.